classical economics & relative prices. classical economics classical economics relies on three...

Classical Economics & Classical Economics & Relative PricesRelative Prices

Classical EconomicsClassical Economics

Classical economics relies on three Classical economics relies on three main assumptions:main assumptions:


Classical economics relies on three Classical economics relies on three main assumptions:main assumptions: Markets are perfectly competitiveMarkets are perfectly competitive All prices are flexibleAll prices are flexible Markets clear (equilibrium)Markets clear (equilibrium)


Classical economics relies on three Classical economics relies on three main assumptions:main assumptions: Markets are perfectly competitiveMarkets are perfectly competitive All prices are flexibleAll prices are flexible Markets clear (equilibrium)Markets clear (equilibrium)

One key result is that all real One key result is that all real variables are independent of variables are independent of monetary policy (money neutrality)monetary policy (money neutrality)

Savings, Investment, and the Savings, Investment, and the Trade BalanceTrade Balance

Recall that in a closed economy, demand for Recall that in a closed economy, demand for loanable funds (supply of marketable loanable funds (supply of marketable securities) must equal the supply of loanable securities) must equal the supply of loanable funds (demand for marketable securities)funds (demand for marketable securities)

Savings, Investment, and the Savings, Investment, and the Trade BalanceTrade Balance

Recall that in a closed economy, demand for Recall that in a closed economy, demand for loanable funds (supply of marketable loanable funds (supply of marketable securities) must equal the supply of loanable securities) must equal the supply of loanable funds (demand for marketable securities)funds (demand for marketable securities)

S = I + (G-T)S = I + (G-T)

S = Private SavingsS = Private Savings

I = Private InvestmentI = Private Investment

(G-T) = Government Deficit/Surplus(G-T) = Government Deficit/Surplus

Savings/Investment in a Closed Savings/Investment in a Closed EconomyEconomy

Without access to world Without access to world capital markets, a capital markets, a country’s private saving is country’s private saving is the sole source of funds. the sole source of funds. Therefore, the domestic Therefore, the domestic interest rate must adjust interest rate must adjust to insure that S = I + to insure that S = I + (G-T)(G-T)

In this example, the In this example, the domestic interest rate is domestic interest rate is equal to 10% and S = I +equal to 10% and S = I +(G-T) = 300(G-T) = 300

What will happen if we What will happen if we expose this country to expose this country to trade?trade?

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Savings in the Open Savings in the Open EconomyEconomy

In an open economy, the rest of the In an open economy, the rest of the world becomes an added source of world becomes an added source of demand/supply of marketable demand/supply of marketable securitiessecurities

S = I + (G-T) + NXS = I + (G-T) + NX

Further, perfect capital mobility Further, perfect capital mobility insures that all countries have the insures that all countries have the same (risk adjusted) real interest rate.same (risk adjusted) real interest rate.


Again, a trade deficit implies NX<0Again, a trade deficit implies NX<0 Therefore, S – (I – (G-T)) = NX < 0Therefore, S – (I – (G-T)) = NX < 0


Again, a trade deficit implies NX<0Again, a trade deficit implies NX<0 Therefore, S – (I – (G-T)) = NX < 0Therefore, S – (I – (G-T)) = NX < 0 A country with a trade deficit is A country with a trade deficit is

borrowing from the rest of the worldborrowing from the rest of the world That is, domestic supply of That is, domestic supply of

marketable securities is greater marketable securities is greater than domestic demandthan domestic demand

Adding Net Exports to Adding Net Exports to Capital MarketsCapital Markets

Suppose that the Suppose that the prevailing world (real) prevailing world (real) interest rate is 6%interest rate is 6%

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At 6%,At 6%, S = $100S = $100 I + (G-T) = $500I + (G-T) = $500 NX = $100 - $500 = -NX = $100 - $500 = -

$400$400

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Suppose that the Suppose that the prevailing world (real) prevailing world (real) interest rate is 14%interest rate is 14% S = $500S = $500 I + (G-T) = $100I + (G-T) = $100 NX = $500 - $100 = NX = $500 - $100 =

$400$400

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Where does the world Where does the world interest rate come from?interest rate come from?

Aggregate world savings is Aggregate world savings is the sum of private savings the sum of private savings across countriesacross countries

Aggregate Private Aggregate Private Investment and Investment and Government Deficits are Government Deficits are also summed over all also summed over all countriescountries

By definition, NX summed By definition, NX summed over all countries must over all countries must equal zero. Therefore, at equal zero. Therefore, at the real world equilibrium the real world equilibrium interest rate, interest rate, S = I + (G-T)S = I + (G-T)

In this example, r = 11%In this example, r = 11%

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Example: An increase in Example: An increase in productivity productivity

Suppose that trade is Suppose that trade is initially balanced. A rise initially balanced. A rise in productivity increases in productivity increases investment demandinvestment demand

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In a closed economy, In a closed economy, interest rates would riseinterest rates would rise

In an open economy, the In an open economy, the trade deficit would trade deficit would increase. In the case, the increase. In the case, the deficit increases from deficit increases from zero to -$15,000zero to -$15,000

Do interest rates rise at Do interest rates rise at all?all?

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World Capital MarketsWorld Capital Markets A country’s ability to influence world interest A country’s ability to influence world interest

rates depends on its size relative to the world rates depends on its size relative to the world economy (recall, global interest rates are economy (recall, global interest rates are determined such that global capital markets determined such that global capital markets clear)clear)

The US makes up roughly 35% of the global The US makes up roughly 35% of the global economy. Therefore, the US can significantly economy. Therefore, the US can significantly influence global interest rates (as can Japan, influence global interest rates (as can Japan, EU, and China)EU, and China)

The rest of the world has little influence unless The rest of the world has little influence unless it acts as a unified group (Latin American it acts as a unified group (Latin American Financial Crisis, Asian Crisis)Financial Crisis, Asian Crisis)

Exchange Rates and Price Exchange Rates and Price LevelsLevels

The Law of One Price The Law of One Price (LOOP) states that the (LOOP) states that the same product should same product should cost the same in every cost the same in every locationlocation

For example, suppose For example, suppose that the price of a that the price of a television is $200 in the television is $200 in the US and E190 in Europe. US and E190 in Europe. The current exchange The current exchange rate is $1.17/Erate is $1.17/E




P* = E190 (E Price in P* = E190 (E Price in Europe)Europe)




What should happen What should happen here?here?


eP* = ($1.17/E)(E190)eP* = ($1.17/E)(E190)

= $222.30= $222.30


The Law of One Price The Law of One Price (LOOP) states that the (LOOP) states that the same product should cost same product should cost the same in every locationthe same in every location

For example, suppose that For example, suppose that the price of a television is the price of a television is $200 in the US and E190 in $200 in the US and E190 in Europe. The current Europe. The current exchange rate is $1.17/Eexchange rate is $1.17/E

What should happen here?What should happen here? A profit can be made by A profit can be made by

buying TVs in the US and buying TVs in the US and selling them in Europe.selling them in Europe.


eP* = ($1.17/E)(E190)eP* = ($1.17/E)(E190)

= $222.30= $222.30



LOOP states that in LOOP states that in equilibrium, no such equilibrium, no such profits can occur. profits can occur. Therefore, P = eP*Therefore, P = eP*




If the price of a TV is If the price of a TV is $200 in the US and E190 $200 in the US and E190 in Europe, the implied in Europe, the implied exchange rate is $1.05/Eexchange rate is $1.05/E





P = $200P = $200

P* = E190P* = E190

P = eP*P = eP*





P = $200P = $200

P* = E190P* = E190

P = eP*P = eP*

e = P/P* = $200/E190e = P/P* = $200/E190

= $1.05/E= $1.05/E

Purchasing Power ParityPurchasing Power Parity Purchasing power parity (PPP) is simply LOOP applied to Purchasing power parity (PPP) is simply LOOP applied to

general price indicesgeneral price indices

P = eP*P = eP*



P = eP*P = eP*

A more useful form of PPP is A more useful form of PPP is

%Change in e = Inflation – Inflation*%Change in e = Inflation – Inflation*



P = eP*P = eP*

A more useful form of PPP is A more useful form of PPP is

%Change in e = Inflation – Inflation*%Change in e = Inflation – Inflation*

For example, if the US inflation rate (annual) is 4% while For example, if the US inflation rate (annual) is 4% while the annual European inflation rate is 2%, the the dollar the annual European inflation rate is 2%, the the dollar should depreciate by 2% over the year.should depreciate by 2% over the year.

PPP and the PPP and the “Fundamentals”“Fundamentals”

Again, recall that PPP gives the following Again, recall that PPP gives the following formula for the nominal exchange rate:formula for the nominal exchange rate:

e = P/P*e = P/P*



e = P/P*e = P/P* Further, the quantity theory give the price Further, the quantity theory give the price

level as a function of money and outputlevel as a function of money and output

P = MV/YP = MV/Y



e = P/P*e = P/P* Further, the quantity theory give the price Further, the quantity theory give the price

level as a function of money and outputlevel as a function of money and output

P = MV/YP = MV/Y Combining the two, Combining the two,

e = (V/V*)(M/M*)(Y*/Y)e = (V/V*)(M/M*)(Y*/Y) V,M,and Y are exchange rate “fundamentals”V,M,and Y are exchange rate “fundamentals”

PPP and the Real PPP and the Real Exchange RateExchange Rate

While the nominal exchange rate is While the nominal exchange rate is defined as the dollar price of foreign defined as the dollar price of foreign currency, the real exchange rate is currency, the real exchange rate is defined as the price of foreign goods in defined as the price of foreign goods in terms of domestic goodsterms of domestic goods

q = eP*/Pq = eP*/P

PPP and the Real PPP and the Real Exchange RateExchange Rate

While the nominal exchange rate is While the nominal exchange rate is defined as the dollar price of foreign defined as the dollar price of foreign currency, the real exchange rate is currency, the real exchange rate is defined as the price of foreign goods in defined as the price of foreign goods in terms of domestic goodsterms of domestic goods

q = eP*/Pq = eP*/P

PPP implies that the real exchange PPP implies that the real exchange is always constant (actually, its is always constant (actually, its equal to 1)equal to 1)

Interest Rate ParityInterest Rate Parity Interest rate parity is the Interest rate parity is the

asset equivalent of PPP. asset equivalent of PPP. It states that all assets It states that all assets should be expected to should be expected to earn the same returnearn the same return

For example, suppose For example, suppose that the interest rate in that the interest rate in the US is 5%, the interest the US is 5%, the interest rate in Europe is 7%,, the rate in Europe is 7%,, the current exchange rate is current exchange rate is $1.15/E and the $1.15/E and the anticipated exchange anticipated exchange rate in a year is $1.10/Erate in a year is $1.10/E




Each $1 invested in the Each $1 invested in the US will be worth $1.05 in US will be worth $1.05 in a year. How about each $ a year. How about each $ invested in Europe?invested in Europe?




Each $1 invested in the Each $1 invested in the US will be worth $1.05 in US will be worth $1.05 in a year. How about each a year. How about each $1 invested in Europe?$1 invested in Europe?

$1 = (1/1.15) = .87E$1 = (1/1.15) = .87E

.87E(1.07) = .93E.87E(1.07) = .93E

.93E ($1.10/E) = $1.02.93E ($1.10/E) = $1.02




Each $1 invested in the Each $1 invested in the US will be worth $1.05 in US will be worth $1.05 in a year. How about each a year. How about each $1 invested in Europe?$1 invested in Europe?

$1 = (1/1.15) = .87E$1 = (1/1.15) = .87E.87E(1.07) = .93E.87E(1.07) = .93E.93E ($1.10/E) = $1.02.93E ($1.10/E) = $1.02

Even with the higher Even with the higher return in Europe, the 5% return in Europe, the 5% appreciation of the dollar appreciation of the dollar makes the US asset a makes the US asset a better investment. better investment. Therefore, funds will flow Therefore, funds will flow to the US.to the US.

Interest Rate ParityInterest Rate Parity

Interest parity states that Interest parity states that exchange rates should be exchange rates should be expected to adjust such that expected to adjust such that assets pay equal returns across assets pay equal returns across countriescountries

(1+i) = (1+i*)(e’/e)(1+i) = (1+i*)(e’/e)


Interest parity states that exchange rates Interest parity states that exchange rates should be expected to adjust such that assets should be expected to adjust such that assets pay equal returns across countriespay equal returns across countries

(1+i) = (1+i*)(e’/e)(1+i) = (1+i*)(e’/e) A more useful form isA more useful form is

i – i* = % change in ei – i* = % change in e For example, if the interest rate in the US is For example, if the interest rate in the US is

5% and the interest rate in Japan is 2%, the 5% and the interest rate in Japan is 2%, the dollar should depreciate by 3% against the Yendollar should depreciate by 3% against the Yen


Interest parity states that exchange rates Interest parity states that exchange rates should be expected to adjust such that assets should be expected to adjust such that assets pay equal returns across countriespay equal returns across countries

(1+i) = (1+i*)(e’/e)(1+i) = (1+i*)(e’/e) A more useful form isA more useful form is

i – i* = % change in ei – i* = % change in e For example, if the interest rate in the US is For example, if the interest rate in the US is

5% and the interest rate in Japan is 2%, the 5% and the interest rate in Japan is 2%, the dollar should depreciate by 3% against the Yendollar should depreciate by 3% against the Yen

Interest rate parity fails just as badly as PPP. Interest rate parity fails just as badly as PPP.

Interest Rate Parity & PPPInterest Rate Parity & PPP

Recall that PPP gives the following:Recall that PPP gives the following:

% change in e = Inflation – Inflation*% change in e = Inflation – Inflation*



% change in e = Inflation – Inflation*% change in e = Inflation – Inflation* Interest Parity gives the following:Interest Parity gives the following:

i – i* = % change in e i – i* = % change in e




i – i* = % change in e i – i* = % change in e Combining them gives usCombining them gives us

i – i* = Inflation – Inflation*i – i* = Inflation – Inflation*






i – Inflation = i* - Inflation*i – Inflation = i* - Inflation*






i – Inflation = i* - Inflation*i – Inflation = i* - Inflation*

r = r*r = r*

Summary of Classical Exchange Summary of Classical Exchange Rate TheoryRate Theory

Real interest differentials across countries Real interest differentials across countries are zero.are zero.

The trade balance is equal to S – (I + (G-T)) The trade balance is equal to S – (I + (G-T)) at the world interest rateat the world interest rate

Real exchange rates are constantReal exchange rates are constant Nominal Exchange rates are related to the Nominal Exchange rates are related to the

“fundamentals”“fundamentals”e = (V/V*)(M/M*)(Y*/Y)e = (V/V*)(M/M*)(Y*/Y)

There is no obvious correlation between There is no obvious correlation between trade balances, interest rates and exchange trade balances, interest rates and exchange ratesrates

Exchange Rates & the Exchange Rates & the Fundamentals (JPY/USD)Fundamentals (JPY/USD)

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Exchange Rates & the Exchange Rates & the Fundamentals (GBP/USD)Fundamentals (GBP/USD)

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Explaining Deviations from Explaining Deviations from PPPPPP

Transportation costs, tariffs, taxes, Transportation costs, tariffs, taxes, etc. interfere with LOOPetc. interfere with LOOP

Non-Traded goodsNon-Traded goods Changes in Terms of TradeChanges in Terms of Trade Price indices are constructed Price indices are constructed

differentlydifferently Fixed prices in the short run Fixed prices in the short run

(Keynesian Economics)(Keynesian Economics)

Trading Costs: An ExampleTrading Costs: An Example

Suppose that the price of gold in Britain Suppose that the price of gold in Britain is L 210 while the price of gold in the is L 210 while the price of gold in the US is $300US is $300



The LOOP exchange rate (GBP/USD)will The LOOP exchange rate (GBP/USD)will be equal to be equal to e = P*/P = L 210 / $300 = L.7/$e = P*/P = L 210 / $300 = L.7/$



The LOOP exchange rate (USD/GBP) will The LOOP exchange rate (USD/GBP) will be equal to be equal to

e = P/P* = $300 / L210 = $1.43/Le = P/P* = $300 / L210 = $1.43/L If the exchange rate deviates from .1.43, If the exchange rate deviates from .1.43,

profits from arbitrage would be profits from arbitrage would be P – eP* (Buy in GB, sell in US)P – eP* (Buy in GB, sell in US)eP* - P (Buy in US, sell in GB)eP* - P (Buy in US, sell in GB)


Now, assume a $10 trading costNow, assume a $10 trading cost Profits from arbitrage would now be Profits from arbitrage would now be

P – (eP*+10) (Buy in GB, sell in US)P – (eP*+10) (Buy in GB, sell in US)

eP* - (P+10) (Buy in US, sell in GB)eP* - (P+10) (Buy in US, sell in GB)

Trading Costs: An ExampleTrading Costs: An Example Now, assume a $10 trading costNow, assume a $10 trading cost Profits from arbitrage would now be Profits from arbitrage would now be

P – (eP*+10) (Buy in GB, sell in US)P – (eP*+10) (Buy in GB, sell in US)eP* - (P+10) (Buy in US, sell in GB)eP* - (P+10) (Buy in US, sell in GB)

Solving for the exchange rate gives us a range Solving for the exchange rate gives us a range in which arbitrage is not profitablein which arbitrage is not profitable

(P-10)/P* < e < (P+10)/P*(P-10)/P* < e < (P+10)/P*1.38 < e < 1.471.38 < e < 1.47


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LowerUpperActual

Non-Traded Goods: An Non-Traded Goods: An ExampleExample

Suppose that in addition to gold, we add Suppose that in addition to gold, we add theatre tickets. Theatre tickets in the US cost theatre tickets. Theatre tickets in the US cost $40 while in Britain, similar tickets cost L 30. $40 while in Britain, similar tickets cost L 30. Further, assume that the price index is defined Further, assume that the price index is defined (in both Britain and the US) as P = .3(Tickets) (in both Britain and the US) as P = .3(Tickets) + .7(Gold)+ .7(Gold)


Suppose that in addition to gold, we add Suppose that in addition to gold, we add theatre tickets. Theatre tickets in the US cost theatre tickets. Theatre tickets in the US cost $40 while in Britain, similar tickets cost L 30. $40 while in Britain, similar tickets cost L 30. Further, assume that the price index is defined Further, assume that the price index is defined (in both Britain and the US) as P = .3(Tickets) (in both Britain and the US) as P = .3(Tickets) + .7(Gold)+ .7(Gold)

CPI = .3(40) + .7(300) = $222CPI = .3(40) + .7(300) = $222 CPI* = .3(30) + .7(210) = L156CPI* = .3(30) + .7(210) = L156


CPI* = .3(30) + .7(210) = L156CPI* = .3(30) + .7(210) = L156 CPI = .3(40) + .7(300) = $222CPI = .3(40) + .7(300) = $222

Arbitrage will insure the nominal exchange Arbitrage will insure the nominal exchange rate will equal rate will equal E = P/P* = 300/210 = $1.43/LE = P/P* = 300/210 = $1.43/L


CPI* = .3(30) + .7(210) = L156CPI* = .3(30) + .7(210) = L156 CPI = .3(40) + .7(300) = $222CPI = .3(40) + .7(300) = $222

Arbitrage will insure the nominal exchange Arbitrage will insure the nominal exchange rate will equal rate will equal e = P/P* = 300/210 = $1.43/Le = P/P* = 300/210 = $1.43/L

The real exchange rate equalsThe real exchange rate equals q = e(CPI*/CPI) = 1.43(156/222) = 1q = e(CPI*/CPI) = 1.43(156/222) = 1


Suppose that the price of a theatre ticket in Suppose that the price of a theatre ticket in the US increases to $50. the US increases to $50.


Suppose that the price of a theatre ticket in Suppose that the price of a theatre ticket in the US increases to $50.the US increases to $50.

CPI* = .3(30) + .7(210) = L156CPI* = .3(30) + .7(210) = L156 CPI = .3(50) + .7(300) = $225CPI = .3(50) + .7(300) = $225



CPI* = .3(30) + .7(210) = L156CPI* = .3(30) + .7(210) = L156 CPI = .3(50) + .7(300) = $225CPI = .3(50) + .7(300) = $225

the nominal exchange rate stays atthe nominal exchange rate stays at e = P/P* = 300/210 = $1.43/Le = P/P* = 300/210 = $1.43/L



CPI* = .3(30) + .7(210) = L156CPI* = .3(30) + .7(210) = L156 CPI = .3(50) + .7(300) = $225CPI = .3(50) + .7(300) = $225

the nominal exchange rate stays atthe nominal exchange rate stays at e = P/P* = 300/210 = $1.43/Le = P/P* = 300/210 = $1.43/L

The real exchange rate equalsThe real exchange rate equals q = e(CPI*/CPI) = 1.43(156/225) = .991 (A real q = e(CPI*/CPI) = 1.43(156/225) = .991 (A real

appreciation)appreciation)

Relative Prices and Relative Prices and Classical EconomicsClassical Economics

Classical theory begins with the real Classical theory begins with the real exchange rate (q)exchange rate (q)

Relative Prices and Relative Prices and Classical EconomicsClassical Economics

Classical theory begins with the real Classical theory begins with the real exchange rate (q)exchange rate (q)

Given movements of the real exchange Given movements of the real exchange rate, the nominal exchange rate evolves rate, the nominal exchange rate evolves according to according to

e = q(Fundamentals)e = q(Fundamentals)

= q(V/V*)(M/M*)(Y*/Y)= q(V/V*)(M/M*)(Y*/Y)

ExampleExample

The US dollar experienced a sharp The US dollar experienced a sharp appreciation during the eighties.appreciation during the eighties.

ExampleExample

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ExampleExample

The US dollar experienced a sharp The US dollar experienced a sharp appreciation during the eighties.appreciation during the eighties.

This could be explained by an increase This could be explained by an increase in the relative price of non-tradeablesin the relative price of non-tradeables

Globalization lowered manufactured goods pricesGlobalization lowered manufactured goods prices Falling equipment prices (computers)Falling equipment prices (computers) Rising cost of services (healthcare)Rising cost of services (healthcare)

This, however, can’t explain the decline This, however, can’t explain the decline in the dollar in the late eightiesin the dollar in the late eighties

Real exchange rates and Real exchange rates and real interest differentialsreal interest differentials

Recall the interest parity conditionRecall the interest parity condition (i-i*) = %change in e(i-i*) = %change in e

Subtracting inflation from both Subtracting inflation from both sides gives us a real interest parity sides gives us a real interest parity conditioncondition (r-r*) = %change in q(r-r*) = %change in q

Relative Prices and the Relative Prices and the Trade BalanceTrade Balance

(r-r*) = %change in q(r-r*) = %change in q Therefore, a real Therefore, a real

depreciation (an depreciation (an increase in q) forces increase in q) forces a rise in domestic a rise in domestic interest rates (to interest rates (to compensate for compensate for declining dollar declining dollar values)values)

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Relative Prices and the Relative Prices and the Trade BalanceTrade Balance

Higher interest rates Higher interest rates increase domestic increase domestic savings while savings while lowering domestic lowering domestic investment. This investment. This improves the trade improves the trade balancebalance

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Classical Exchange Rate Theory Classical Exchange Rate Theory and Relative Pricesand Relative Prices

Real exchange rates are determined by Real exchange rates are determined by relative price changesrelative price changes

Nominal Exchange rates are related to the Nominal Exchange rates are related to the real exchange rate plus the real exchange rate plus the “fundamentals”“fundamentals”

e = q (V/V*)(M/M*)(Y*/Y)e = q (V/V*)(M/M*)(Y*/Y)

Real interest differentials across countries Real interest differentials across countries are positively related to real exchange rate are positively related to real exchange rate changeschanges

Real depreciations (appreciations) will Real depreciations (appreciations) will improve (worsen) the trade balances.improve (worsen) the trade balances.

classical economics & relative prices. classical economics classical economics relies on three...

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